Highlights of RBI’s Third Bi-monthly Monetary Policy Statement, 2017-18:

Policy Measures

• The Monetary Policy Committee (MPC) decided to reduce the policy repo rate under the liquidity adjustment facility (LAF) from 6.25% to 6.00% with immediate effect.
• Consequently, the reverse repo rate under the LAF stands adjusted to 5.75%, and the marginal standing facility (MSF) rate and the Bank Rate to 6.25%.
• Inflation excluding food and fuel, which has hitherto been sticky, has fallen significantly over past three months. These factors along with the normal and well distributed rainfall and the smooth rollout of the GST opened up some space for Monetary Policy accommodation. Accordingly, the MPC decided by a vote of 4 to 2 to reduce the policy rate by 25 basis points.
• The decision of the MPC is consistent with a neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth. 

 Assessment

Impulses of growth have spread across the global economy albeit still lacking the strength of a self-sustaining recovery. Among the AEs, the US has expanded at a faster pace in Q2 after a weak Q1, supported mostly by steadily improving labour market conditions. In the Euro area, the recovery has broadened across constituent economies on the back of falling unemployment and a pickup in private consumption.  In Japan, a modest but steady expansion has been taking hold, underpinned mostly by strengthening exports. Among EMEs, growth has regained some lost ground in China in Q2.  The Russian economy has emerged out of two years of recession. In Brazil, a fragile recovery remains vulnerable to political uncertainty and a still depressed labour market. South Africa is in a technical recession as economic activity in continues to be beset by structural and institutional bottlenecks. The modest firming up of global demand and stable commodity prices have supported global trade volumes, reflected in rising exports and imports in key economies. In the second half of July, crude prices have risen modestly out of bearish territory on account of inventory drawdown in the US, but the supply overhang persists. Chinese demand has fuelled a recent rally in metal prices. However, inflation is well below target in most AEs and is subdued across most EMEs.

International financial markets have been resilient to political uncertainties and volatility has declined. Equity markets in most AEs have registered gains, with indices crossing previous highs in the US. In EMEs, equities have gained on surging global risk appetite.  Bond yields in major AEs have hardened on expectations of monetary policy normalization, while in EMEs fixed-income markets have been generally insulated from the bond sell-off in AEs. In the currency markets, the US dollar weakened further and fell to a multi-month low in July. The euro, which has remained bullish, rallied further on upbeat economic data.  EME currencies largely remained stable and have traded with an appreciating bias.

In India a normal and well-distributed south-west monsoon for the second consecutive year has brightened the prospects of agricultural and allied activities and rural demand. Meanwhile, procurement operations in respect of rice and wheat during the rabi marketing season have been stepped up to record levels.

Industrial performance has weakened in April-May 2017, mainly reflecting a broad-based loss of momentum in manufacturing. The output of consumer non-durables accelerated and underlined the resilience of rural demand. It was overwhelmed, however, by contraction in consumer durables – indicative of still sluggish urban demand – and in capital goods, which points to continuing retrenchment of capital formation in the economy. The weakness in the capex cycle was also evident in the number of new investment announcements falling to a 12-year low in Q1, the lack of traction in the implementation of stalled projects, deceleration in the output of infrastructure goods, and the ongoing deleveraging in the corporate sector. The output of core industries was also dragged down by contraction in electricity, coal and fertiliser production in June, owing to excess inventory and tepid demand. The 78th round of the Reserve Bank’s industrial outlook survey revealed a waning of optimism in Q2 about demand conditions across parameters, and especially on capacity utilisation, profit margins and employment. The manufacturing PMI moderated sequentially to a four-month low in June and in July, the PMI declined into the contraction zone with a decrease in new orders and a deterioration in business conditions, reflecting inter alia the roll out of the GST.

In June, retail inflation measured by year-on-year changes in the CPI plunged to its lowest reading in the series based to 2011-12. This was mainly the outcome of large favourable base effects which are slated to dissipate and reverse from August. Prices of food and beverages, which went into deflation in May 2017 for the first time in the new CPI series, sank further in June as prices of pulses, vegetables, spices and eggs recorded year-on-year declines and inflation moderated across most other sub-groups. . Fuel inflation declined for the second month in succession as international prices of LPG fell and price increases moderated in other categories. Excluding food and fuel, CPI inflation moderated for the third month in succession in June, falling to 4%.

Surplus liquidity conditions persisted in the system, exacerbated by front-loading of budgetary spending by the Government. Surplus liquidity of Rs. 1 trillion was absorbed through issuance of treasury bills (TBs) under the MSS and Rs. 1.3 trillion through CMBs on a cumulative basis so far this financial year. Enduring surplus conditions warranted outright open market sales of Rs.100 billion each on two occasions in June and July. Apart from these operations, net average absorption of liquidity under the LAF was at Rs. 3.1 trillion in June and Rs. 3.0 trillion in July. Reflecting this active liquidity management, the weighted average CMR firmed up and traded about 17 bps below the repo rate on average during June and July.

Merchandise export growth weakened in May and June from the April peak as the value of shipments across commodity groups either slowed or declined. By contrast, import growth remained in double digits, primarily due to a surge in oil imports and stockpiling of gold imports ahead of the implementation of the GST. As import growth continued to outpace export growth, the trade deficit at US$40.1 billion in Q1 was more than double its level a year ago.

Net FDI doubled in April-May 2017 over its level a year ago, flowing mainly into manufacturing, retail and wholesale trade and business services. FPIs made net purchases of US$15.2 billion in domestic debt and equity markets so far (up to July 31), remaining bullish on the outlook for the Indian economy. The level of foreign exchange reserves was US$392.9 billion as on July 28, 2017.

Outlook

The projection of real GVA growth for 2017-18 has been retained at the June 2017 projection of 7.3 per cent, with risks evenly balanced. Business sentiment in the manufacturing sector reflects expectations of moderation of activity in Q2 of 2017-18 from the preceding quarter. Moreover, high levels of stress in twin balance sheets – banks and corporations – are likely to deter new investment. With the real estate sector coming under the regulatory umbrella, new project launches may involve extended gestations and, along with the anticipated consolidation in the sector, may restrain growth, with spillovers to construction and ancillary activities. Also, given the limits on raising market borrowings and taxes by States, farm loan waivers are likely to compel a cutback on capital expenditure, with adverse implications for the already damped capex cycle. At the same time, upsides to the baseline projections emanate from the rising probability of another good kharif harvest, the boost to rural demand from the higher budgetary allocation to housing in rural areas, the significant step-up in the budgetary allocation for roads and bridges, and the growth-enhancing effects of the GST, viz., the shifting of trade from unorganised to organised segments; the reduction of tax cascades; cost, efficiency and competitiveness gains; and synergies in domestic supply chains. External demand conditions are gradually improving and should support the domestic economy.

The second bi-monthly statement projected quarterly average headline inflation in the range of 2.0-3.5 per cent in the first half of the year and 3.5-4.5 per cent in the second half. The actual outcome for Q1 has tracked projections. Looking ahead, as base effects fade, the evolving momentum of inflation would be determined by (a) the impact on the CPI of the implementation of house rent allowances (HRA) under the 7th central pay commission (CPC); (b) the impact of the price revisions withheld ahead of the GST; and (c) the disentangling of the structural and transitory factors shaping food inflation. The inflation trajectory has been updated taking into account all these factors and incorporates the first round impact of the implementation of the HRA award by the Centre. Excluding the HRA impact, which will affect the CPI cumulatively, headline inflation would be a little above 4% by Q4, as against 4.5% inclusive of the HRA in the June statement. However, there are several factors contributing to uncertainty on both sides around this baseline inflation trajectory.

Developmental and Regulatory Policies

The RBI also set out measures to improve policy transmission and financial intermediation in the economy:

The experience with the MCLR system introduced in April 2016 for improving monetary policy transmission has not been entirely satisfactory, even though it has been an advance over the Base Rate system. Given a large part of the floating rate loan portfolio of banks is still anchored on the Base Rate, the RBI will be exploring various options in the near future to make the Base Rate more responsive to changes in cost of funds of banks.

Final guidelines set out for Tri-party Repo aimed to pave the way for a vibrant corporate bond borrowing and lending market, providing better liquidity and price discovery, reducing market cost of capital and allowing access to non-bank finance for a greater number of borrowers in the economy.

Task force to evaluate the existing public and private infrastructure for credit information, assess any data gaps, study the best international practices and provide a road map for the development of a comprehensive near real-time public credit registry for India.

Guidelines on Liquidity Coverage Ratio (LCR) have been revised such that reserves held by banks incorporated in India with a foreign central bank, in excess of the reserve requirement in the host country, should be treated as High Quality Liquid Assets (HQLAs), subject to certain conditions.

The circular to operationalize the scheme of simplified hedging facility has been finalized. The scheme aims to simplify the process for hedging exchange rate risk by reducing documentation requirements and avoiding prescriptive stipulations regarding products, purpose and hedging flexibility.

Separate limit of Interest Rate Futures (IRFs) for FPIs to be introduced to ensure FPIs’ access to futures remains uninterrupted during the phase when FPI limits on Government securities are under auction. It is proposed to allocate FPIs a separate limit of Rs. 5,000 crore for long position in IRFs. The limits prescribed for investment by FPIs in Government securities will then be exclusively available for acquiring such securities.